Even as the government is sending signals that the new provision of General Anti-Avoidance Rules (GAAR) will not target participatory notes (P-Notes) issued by foreign institutional investors (FIIs), some FIIs are already pulling the plug on such investments which will affect the flow of money into the capital markets.

International brokerage, CLSA in its March 27 note to clients in India said it would not be issuing any further participatory notes or P-Notes starting April 1 and will refrain from increasing its current P-Note book in India. CLSA is not the only one to do so and most of the international brokerages who have the maximum exposure towards P-notes are considering similar moves. Such brokerage houses include Goldman Sachs, Citigroup, Barclays, J P Morgan, HSBC and Morgan Stanley to name a few.

FIIs who are not registered in India and who cannot directly subscribe to or buy equity shares in India use such P-Notes to gain access to the market. Since these notes are not issued in the country and are used outside, they are also called offshore derivative instruments or ODIs.

In India, overseas clients of FIIs and their sub-accounts use such instruments to invest in Indian stock market. For example, Indian-based brokerages buy India-based securities and then issue participatory notes to foreign investors. Any dividends or capital gains collected from the underlying securities go back to the investors.

FIIs invested a total of Rs 1.83 lakh crore through P-Notes as on February 2012, Securities and Exchange Board of India’s data shows. As per the data, the investments in P-Notes contributed a total of 16.4 per cent of the total assets under the custody of FIIs in the same period.

The note sent by Fraser Howie, head of structured products at CLSA, talks about the possible tax implication on foreign institutional investors or FIIs if the GAAR guidelines are implemented.

“Under the GAAR, disposals of shares post 1 April 2012 will likely be subject to tax at some point in time but the exact nature of that tax is not clear.  CLSA has taken the position not to increase its current Indian P-Note book as a way of minimizing the possible tax exposure. For CLSA or any other P-Note issuer the tax liability must rest with the end ODI investor, the end beneficiary of the economic gain. CLSA will therefore be working with its Indian legal counsel, tax advisors and clients to ensure that the suitable documentation or even withholding is put in place to properly reflect the risks of the ODI structure,” Howie noted.

Vikas Khemani, president & head of wholesale capital markets unit of Edelweiss Financial Services Limited said, “The uncertainty still prevails and till the time there is clarity on implementation of GAAR, investments through Mauritius route and P-Notes, people will continue to wait and watch and tread cautiously.”

Even though market experts have been quoting Singapore as the next destination, as the government is busy clamping Mauritius treaty, GAAR could over ride tax treaties with Singapore too.

According to a Nomura report dated March 26, tax implications on P-Notes and Offshore Derivative Instruments structure needs to be re-evaluated in view of retrospective amendments to the terms transfer, asset and property along with introduction of GAAR.

News reports on Tuesday quoted unnamed sources who hinted at the possibility of P-Notes being kept out of the purview of the GAAR saw the 30-stock benchmark index Sensex surge 204.58 points or 1.2 per cent.

Also Read:

FII Holdings Through P-Notes In India Hit 18-Month High

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